INTRODUCTION

TO
CAPITAL
STRUCTURE
THEORY AND
ANALYSIS

Expenditure of Hdfc bank.’. The purpose and

scope of the project can be listed as:
  Understanding the organizational
structure and functioning of Hdfc bank.
 Analysing and comparing the financial
health of the firms in the Indian This is a
Report on the ‘Capital Structure and
Capital Pharma Industry.
 Identifying and analysing the capital
structure of Ranbaxy.
 Conducting a Review of the Capital
Expenditure done at Hdfc bank.
 Identifying loopholes in the functioning
and in the area of study and
recommending the suggestions for the
same.
Following are the limitations of the study:

 Balance sheets of only 3 years have been

studied but the company is in operation for
so many years.
 Only specific tools (i.e. ratio analysis) have
been used for data analysis, while so many
other tools are also there.
 Organizational rules & regulations.

 Availability of data. Financial figures for

2008 of Ranbaxy were not available.
 Limitations of the financial tools used.
Litreture of review on Capital
Structure
CAPITAL STRUCTURE IS A MIX OF DEBT AND
EQUITY CAPITAL MAINTAINED BY A FIRM. CAPITAL
STRUCTURE IS ALSO REFERRED AS FINANCIAL
STRUCTURE OF
A FIRM. THE CAPITAL STRUCTURE OF A FIRM IS VERY
IMPORTANT SINCE IT RELATED TO THE ABILITY OF THE
FIRM
TO MEET THE NEEDS OF ITS STAKEHOLDERS.
MODIGLIANI
AND MILLER (1958) WERE THE FIRST ONES TO
LANDMARK
THE TOPIC OF CAPITAL STRUCTURE AND THEY ARGUED
THAT
CAPITAL STRUCTURE WAS IRRELEVANT IN
DETERMINING THE
FIRM’S VALUE AND ITS FUTURE PERFORMANCE. ON THE
OTHER HAND, LUBATKIN AND CHATTERJEE (1994) AS
WELL AS MANY OTHER STUDIES HAVE PROVED THAT
THERE
EXISTS A RELATIONSHIP BETWEEN CAPITAL
STRUCTURE AND
FIRM VALUE. MODIGLIANI AND MILLER (1963)
SHOWED THAT THEIR MODEL IS NO MORE EFFECTIVE IF
TAX WAS TAKEN INTO CONSIDERATION SINCE TAX
SUBSIDIES ON DEBT INTEREST PAYMENTS WILL CAUSE
A
RISE IN FIRM VALUE WHEN EQUITY IS TRADED FOR
DEBT.
IN MORE RECENT LITERATURES, AUTHORS HAVE
SHOWED THAT THEY ARE LESS INTERESTED ON HOW
CAPITAL STRUCTURE AFFECTS THE FIRM VALUE.
INSTEAD
OF THE FIRM. MODIGLIANI AND MILLER (1963) ARGUED
THAT THE CAPITAL STRUCTURE OF A FIRM SHOULD
COMPOSE ENTIRELY OF DEBT DUE TO TAX DEDUCTIONS
ON INTEREST PAYMENTS. HOWEVER, BRIGHAM AND
GAPENSKI (1996) SAID THAT, IN THEORY, THE
MODIGLIANI-MILLER (MM) MODEL IS VALID. BUT, IN
PRACTICE, BANKRUPTCY COSTS EXIST AND THESE
COSTS
ARE DIRECTLY PROPORTIONAL TO THE DEBT LEVEL OF
THE
FIRM. HENCE, AN INCREASE IN DEBT LEVEL CAUSES AN
INCREASE IN BANKRUPTCY COSTS. THEREFORE, THEY
ARGUE THAT THAT AN OPTIMAL CAPITAL STRUCTURE
CAN
ONLY BE ATTAINED IF THE TAX SHELTERING BENEFITS
PROVIDED AN INCREASE IN DEBT LEVEL IS EQUAL TO
THE
BANKRUPTCY COSTS. IN THIS CASE, MANAGERS OF THE
FIRMS SHOULD BE ABLE TO IDENTIFY WHEN THIS
OPTIMAL CAPITAL STRUCTURE IS ATTAINED AND TRY TO
MAINTAIN IT AT THE SAME LEVEL. THIS IS THE ONLY
WAY THAT THE FINANCING COSTS AND THE WEIGHTED
AVERAGE COST OF CAPITAL (WACC) ARE MINIMISED
THEREBY INCREASING FIRM VALUE AND CORPORATE
PERFORMANCE.
Capital Structure: Theory and
Analysis
Capital Structure

Financing decisions involve raising funds for the firm. It is concerned

with formulation and designing of capital structure or leverage. The
most crucial decision of any company is involved in the formulation
of its appropriate capital structure. The best design or structure of the
capital of a company helps the management to achieve its ultimate
objectives of minimising overall cost of capital, maximising
profitability and also maximising the value of the firm.
The capital structure decision of a firm is concerned with the
determination of debt equity composition. Capital structure ordinarily
implies the proportion of debt and equity in the total capital of a
company. The term capital may be defined as the long – term funds
of the firm. Capital is the aggregation of the items appearing on the
left hand side of the balance sheet minus current liabilities.
In other words capital may be expressed as follows:
Capital = Total Assets – Current Liabilities.
Further, capital of a company may broadly be categorised into equity
and debt. The total capital structure of a firm is represented in the
following figure:
 Total Capital
Financial Leverage

This ratio indicates the effects on earnings by rise of fixed cost funds.
It refers to use the use of debt in the capital structure. Financial
leverage arises when a firm deploys debt funds with fixed charge. The
ratio is calculated with theEquity
following:
Capital Debt Capital
 Earnings before interest and tax / Earnings after interest –
The higher the ratio, the lower the cushion for paying interest on
borrowings. A low ratio indicates a low interest outflow and
consequently lower borrowings. A high ratio is risky and
Equity Share Capital Term Loans
constitutes a strain on profits. This ratio is considered along with
Preference Share Capital Debentures
the operating ratio, gives a fairly and accurate idea about the
Share Premium Deferred Payments Liabilities
firm’s earnings, its fixed costs and the interest expenses on long
term borrowings. Retained Earnings Other Long term Debt

 Earnings per Share – Higher financial leverage leads to higher

EBIT resulting in higher EPS, if other things remain constant.
Financial leverage affects the variability and expected level of
EPS. The more debt the firm employs the higher its financial
leverage. Financial leverage generally raises expected EPS, but
it also increases the riskiness of securities as the debt / asset
ratio rises.

EBI
Financial
T
Leverage =
EBT

EBIT – Earnings Before Interest and Tax

EBT – Earnings Before Taxes.
Consider Two Hypothetical Firms
Firm U Firm L

No debt 10,000 of 12% debt

20,000 in assets 20,000 in assets

40% tax rate 40% tax rate

Both firms have same operating leverage, business risk, and EBIT of
3,000. They differ only with respect to use of debt.

Impact of Leverage on Returns

Firm U Firm L (Fig.
in Rs’000)
EBIT 3,000 3,000
Interest 0 1,200
EBT 3,000 1,800
Taxes (40%) 1, 200 720
NI 1,800 1,080
ROE 9.0% 10.8%

More EBIT goes to investors in Firm L.

Total dollars paid to investors:

 U: NI = Rs.1,800.

 L: NI + Int = Rs.1,080 + Rs.1,200 = Rs.2,280.

 Taxes paid:

 U: Rs.1,200; L: Rs.720.

Now consider the fact that EBIT is not known with certainty.
Determining the impact of uncertainty on stockholder profitability
and risk for Firm U and Firm L
Firm U: Unleveraged
Economy (Fig.
in Rs’000)

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT 2,000 3,000 4,000
Interest 0 0 0
EBT 2,000 3,000 4,000
Taxes (40%) 800 1,200 1,600
NI 1,200 1,800 2,400
Firm L: Leveraged
Economy
(Fig. in Rs’000)

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT* 2,000 3,000 4,000
Interest 1,200 1,200 1,200
EBT 800 1,800 2,800
Taxes (40%) 320 720 1,120
NI 480 1,080 1,680
*Same as for Firm U.

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.

Firm L Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x

U L
Profitability Measures:
 E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%

Risk Measures:
sROIC 2.12% 2.12%
sROE 2.12% 4.24%

Conclusions
 Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital
= EBIT(1-T)/TA) are unaffected by financial leverage.

 L has higher expected ROE: tax savings and smaller equity

base.

 L has much wider ROE swings because of fixed interest

charges. Higher expected return is accompanied by higher
risk.

In a stand-alone risk sense, Firm L’s stockholders see much more risk
than Firm U’s.

U and L: sROIC = 2.12%.

U: sROE = 2.12%.

L: sROE = 4.24%.

 L’s financial risk is sROE - sROIC = 4.24% - 2.12% =

2.12%. (U’s is zero.)

 For leverage to be positive (increase expected ROE), BEP

must be > rd.
  If rd > BEP, the cost of leveraging will be higher than the
inherent profitability of the assets, so the use of financial
leverage will depress net income and ROE.

In the example, E(BEP) = 15% while interest rate = 12%, so

leveraging “works.”

Choosing the Optimal Capital Structure for Hdfc bank.

Based on the ratio analysis done above it can be concluded that
Ranbaxy is an unleveared firm with very less debt component in its
capital structure. The company is in a position to increase its debt
component by resorting to external debt financing. However it should
be kept in mind that, there could be two opposite effects if debt is
increased in the capita structure. The first effect may be an overall
reduction in the cost of capital as the proportion of debt increases in
the capital structure due to low cost of debt. On the other hand,
because of fixed contractual obligation the financial risk of the
company increases. Thus, it is said that the optimum capital structure
implies a ratio of debt and equity at which weighted average cost of
capital would be least and the market value of the firm would be
highest.
Keeping the above thought in mind I have tried to compute what
would be the optimal capital structure for Ranbaxy Laboratories Ltd.,
based on the following information as per the Annual Report 2005:
EBIT being 37,273,800;
Assuming that the firms expects zero growth
225,557,810 shares outstanding; rs = 12%;
T = 35%; b = 1.0; rRF = 6%;
RPM = 6%.
Estimates of Cost of Debt
Percent financed
with debt, wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%

If company recapitalizes, debt would be issued to repurchase stock.

The Cost of Equity at Different Levels of Debt: Hamada’s Equation

 MM theory implies that beta changes with leverage.
 bU is the beta of a firm when it has no debt (the unlevered
beta)
 bL = bU [1 + (1 - T)(D/S)]

The Cost of Equity for wd = 20%

Use Hamada’s equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.35) (20% / 80%) ]
= 1.16
Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.16 (6%) = 12.98%

Cost of Equity vs. Leverage

 wd D/S bL rs
0% 0.00 1.00 12.00%
20% 0.25 1.16 12.98%
30% 0.43 1.28 13.67%
40% 0.67 1.43 14.60%
50% 1.00 1.65 15.90%
The WACC for wd = 20%
WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 – 0.35) (8%) + 0.8 (12.98%)
WACC = 11.42%
Repeat this for all capital structures under consideration.

WACC vs. Leverage

wd rd rs WACC
0% 0.0% 12.00% 12.00%
20% 8.0% 12.98% 11.42%
30% 8.5% 13.67% 11.23%
40% 10.0% 14.60% 11.36%
50% 12.0% 15.90% 11.85%
Corporate Value for wd = 20%
V = FCF / (WACC-g)
g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).
NOPAT = (Rs.37,273,800)(1-0.35) = Rs.24,227,970

V = Rs.24,227,970/ 0.1142 = Rs.212,153,852.89

Corporate Value vs. Leverage

 wd WACC Corp. Value
0% 12.00% Rs.201,899,750.00
20% 11.42% Rs.212,153,852.89
30% 11.23% Rs.215,791,315.97
40% 11.36% Rs.213,274,383.80
50% 11.85% Rs.204,455,443.04

Debt and Equity for wd = 20%

The value of debt is:
= wd V = 0.2 (Rs.212,153,852.89) = Rs.42,430,770.58.
S=V–D
S = Rs.212,153,852.89 – Rs.42,430,770.58 = Rs.169,723,082.31

Debt and Stock Value vs. Leverage

wd Debt, D Stock Value, S
0% 0 Rs.201,899,750.00
20% Rs.42, 430,770.58 Rs.169,723,082.31
30% Rs.64, 737,394.79 Rs.151,053,921.18
40% Rs.85, 309,753.52 Rs.127,964,630.28
50% Rs.102, 227,721.52 Rs.102,227,721.52
Financial Leverage

This ratio indicates the effects on earnings by rise of fixed cost funds.
It refers to use the use of debt in the capital structure. Financial
leverage arises when a firm deploys debt funds with fixed charge. The
ratio is calculated with the following:
 Earnings before interest and tax / Earnings after interest –
The higher the ratio, the lower the cushion for paying interest on
borrowings. A low ratio indicates a low interest outflow and
consequently lower borrowings. A high ratio is risky and
constitutes a strain on profits. This ratio is considered along with
the operating ratio, gives a fairly and accurate idea about the
firm’s earnings, its fixed costs and the interest expenses on long
term borrowings.
 Earnings per Share – Higher financial leverage leads to higher
EBIT resulting in higher EPS, if other things remain constant.
Financial leverage affects the variability and expected level of
EPS. The more debt the firm employs the higher its financial
leverage. Financial leverage generally raises expected EPS, but
it also increases the riskiness of securities as the debt / asset
ratio rises.

EBI
Financial
T
Leverage =
EBT

EBIT – Earnings Before Interest and Tax

EBT – Earnings Before Taxes.
Consider Two Hypothetical Firms
Firm U Firm L

No debt 10,000 of 12% debt

20,000 in assets 20,000 in assets

40% tax rate 40% tax rate

Both firms have same operating leverage, business risk, and EBIT of
3,000. They differ only with respect to use of debt.

Impact of Leverage on Returns

Firm U Firm L (Fig.
in Rs’000)
EBIT 3,000 3,000
Interest 0 1,200
EBT 3,000 1,800
Taxes (40%) 1, 200 720
NI 1,800 1,080
ROE 9.0% 10.8%

More EBIT goes to investors in Firm L.

Total dollars paid to investors:

 U: NI = Rs.1,800.

 L: NI + Int = Rs.1,080 + Rs.1,200 = Rs.2,280.

 Taxes paid:

 U: Rs.1,200; L: Rs.720.

Now consider the fact that EBIT is not known with certainty.
Determining the impact of uncertainty on stockholder profitability
and risk for Firm U and Firm L
Firm U: Unleveraged
Economy (Fig.
in Rs’000)

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT 2,000 3,000 4,000
Interest 0 0 0
EBT 2,000 3,000 4,000
Taxes (40%) 800 1,200 1,600
NI 1,200 1,800 2,400
Firm L: Leveraged
Economy
(Fig. in Rs’000)

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT* 2,000 3,000 4,000
Interest 1,200 1,200 1,200
EBT 800 1,800 2,800
Taxes (40%) 320 720 1,120
NI 480 1,080 1,680
*Same as for Firm U.

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.

Firm L Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x

U L
Profitability Measures:
 E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%

Risk Measures:
sROIC 2.12% 2.12%
sROE 2.12% 4.24%

Conclusions
 Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital
= EBIT(1-T)/TA) are unaffected by financial leverage.

 L has higher expected ROE: tax savings and smaller equity

base.

 L has much wider ROE swings because of fixed interest

charges. Higher expected return is accompanied by higher
risk.

In a stand-alone risk sense, Firm L’s stockholders see much more risk
than Firm U’s.

U and L: sROIC = 2.12%.

U: sROE = 2.12%.

L: sROE = 4.24%.

 L’s financial risk is sROE - sROIC = 4.24% - 2.12% =

2.12%. (U’s is zero.)

 For leverage to be positive (increase expected ROE), BEP

must be > rd.
  If rd > BEP, the cost of leveraging will be higher than the
inherent profitability of the assets, so the use of financial
leverage will depress net income and ROE.

In the example, E(BEP) = 15% while interest rate = 12%, so

leveraging “works.”

Choosing the Optimal Capital Structure for Hdfc bank.

Based on the ratio analysis done above it can be concluded that
Ranbaxy is an unleveared firm with very less debt component in its
capital structure. The company is in a position to increase its debt
component by resorting to external debt financing. However it should
be kept in mind that, there could be two opposite effects if debt is
increased in the capita structure. The first effect may be an overall
reduction in the cost of capital as the proportion of debt increases in
the capital structure due to low cost of debt. On the other hand,
because of fixed contractual obligation the financial risk of the
company increases. Thus, it is said that the optimum capital structure
implies a ratio of debt and equity at which weighted average cost of
capital would be least and the market value of the firm would be
highest.
Keeping the above thought in mind I have tried to compute what
would be the optimal capital structure for Ranbaxy Laboratories Ltd.,
based on the following information as per the Annual Report 2005:
EBIT being 37,273,800;
Assuming that the firms expects zero growth
225,557,810 shares outstanding; rs = 12%;
T = 35%; b = 1.0; rRF = 6%;
RPM = 6%.
Estimates of Cost of Debt
Percent financed
with debt, wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%

If company recapitalizes, debt would be issued to repurchase stock.

The Cost of Equity at Different Levels of Debt: Hamada’s Equation

 MM theory implies that beta changes with leverage.
 bU is the beta of a firm when it has no debt (the unlevered
beta)
 bL = bU [1 + (1 - T)(D/S)]

The Cost of Equity for wd = 20%

Use Hamada’s equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.35) (20% / 80%) ]
= 1.16
Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.16 (6%) = 12.98%

Cost of Equity vs. Leverage

 wd D/S bL rs
0% 0.00 1.00 12.00%
20% 0.25 1.16 12.98%
30% 0.43 1.28 13.67%
40% 0.67 1.43 14.60%
50% 1.00 1.65 15.90%
The WACC for wd = 20%
WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 – 0.35) (8%) + 0.8 (12.98%)
WACC = 11.42%
Repeat this for all capital structures under consideration.

WACC vs. Leverage

wd rd rs WACC
0% 0.0% 12.00% 12.00%
20% 8.0% 12.98% 11.42%
30% 8.5% 13.67% 11.23%
40% 10.0% 14.60% 11.36%
50% 12.0% 15.90% 11.85%
Corporate Value for wd = 20%
V = FCF / (WACC-g)
g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).
NOPAT = (Rs.37,273,800)(1-0.35) = Rs.24,227,970

V = Rs.24,227,970/ 0.1142 = Rs.212,153,852.89

Corporate Value vs. Leverage

 wd WACC Corp. Value
0% 12.00% Rs.201,899,750.00
20% 11.42% Rs.212,153,852.89
30% 11.23% Rs.215,791,315.97
40% 11.36% Rs.213,274,383.80
50% 11.85% Rs.204,455,443.04

Debt and Equity for wd = 20%

The value of debt is:
= wd V = 0.2 (Rs.212,153,852.89) = Rs.42,430,770.58.
S=V–D
S = Rs.212,153,852.89 – Rs.42,430,770.58 = Rs.169,723,082.31

Debt and Stock Value vs. Leverage

wd Debt, D Stock Value, S
0% 0 Rs.201,899,750.00
20% Rs.42, 430,770.58 Rs.169,723,082.31
30% Rs.64, 737,394.79 Rs.151,053,921.18
40% Rs.85, 309,753.52 Rs.127,964,630.28
50% Rs.102, 227,721.52 Rs.102,227,721.52